Hopes for a soft landing

Can China pull off a managed economic slowdown?

By

KabirChibber

HONG KONG (CBS.MW) -- The masses of tourists from mainland China are among the more peculiar sights in today's Hong Kong.

Those visitors arrive mainly by coach and appear awed at the sight of Westerners and locals making merry along the winding, narrow streets of Lan Kwai Fong in the central part of the island. That the bars and pubs are again full is a sign of how the city is booming.

Hong Kong, turned over to China by the United Kingdom in 1997, had been in an economic slump since the handover, but a recent economic-partnership agreement with Beijing has helped create a new vitality.

Of course, beyond Hong Kong and beyond even its region, mainland China has become the engine of economic growth for the world, and it has been trying to cool its white-hot economy to avoid a hard landing. Some are worried about what an anticipated slowdown next year will mean for international investors and the world economy, particularly if the situation spins out of Beijing's control.

The economy is projected to grow by 9.3 percent this year, but the growth rate is then forecast to slow to 7.8 percent in 2005 and 7 percent in 2006.

Remedying overheating

Serious overheating has occurred in some investment categories, especially in the key construction, automobile and property markets, with worrisome implications for the Chinese financial system.

"Rather than [carry] those risks, the decision was made 12 months ago to bring the economy down to a more sustainable growth rate," recalls Qu Hongbin, senior economist for China at HSBC.

But Qu believes there is no cause for concern. "China is in the middle of a period of massive industrialization and urbanization, but this upturn in investment cannot be sustained," he says. It is important that people do not confuse structural trends with cyclical trends, he adds.

A cooldown also would offer China a chance to further reform the financial sector ahead of banking liberalization in 2006. See full story.

Away from 'growth at all costs'

Slowing growth also would allow the government to address the imbalance between the rural interior provinces the rapidly urbanizing metropolises along the coast, says Linda Yueh, a fellow at the Asia Research Centre of Oxford University. The Chinese government now believes there must be balanced development, which, says Yueh, stands in contrast to a previous strategy of "growth at all costs."

International investors can be expected to feel the pinch of this strategy most acutely in metals and commodities. China's "construction-centric investment boom" has been a major factor behind the increase in prices of such metals as aluminum and copper, according to HSBC's Qu.

The country accounted for more than half the increase in global demand over the past 12 months. Despite this, miners BHP Billiton
BHP, -1.49%
(BLT) and Rio Tinto
RIO, -2.39%
(RIO), shares of which have doubled over the past two years, have continued to forecast high demand and prices in 2005.

"I think the mining companies are the last to feel the effects of slowdowns, because their inventories give the impression that demand and prices are still strong," says Andy Xie, senior regional economist at Morgan Stanley, who expects "weak or struggling" base-metals prices next year.

Domestically, a lower growth rate means China's real estate market, in particular, is expected to suffer after five years of thriving sales. Car production, where overcapacity is estimated between 50 percent and 100 percent, is also projected to slow.

Oxford's Yueh notes that Asian economies that have trading surpluses with China, such as Malaysia and Japan, could also be significantly affected.

Prospects for the yuan, interest rates

Much of the world's focus has not centered on China's economic growth but on whether it will revalue the yuan in the near future. The view in Hong Kong is that this is extremely unlikely.

"There is too much speculation in the financial markets, and the Chinese leaders are very scared on what speculation could do to the Chinese economy," Morgan Stanley's Xie says. "Revaluation is almost inconceivable."

In Yueh's view, Beijing is worried that a revaluation would lead to pressure to revalue again.

Xie says that what the central government seeks is flexibility, which would mean widening the narrow band between which the yuan trades against the U.S. dollar. "Flexibility next year is possible, but they will wait for speculation to cool down," Xie predicts.

On Dec. 8, China Premier Wen Jiabao said the country would move gradually toward an open exchange rate but that a sound banking system and macro-level stability is needed first.

China's decision to raise interest rates by 0.27 basis points to 2.25 percent on Oct. 29 sent the world's financial markets into panic and defined a year in which China's role in the world economy could no longer be ignored.

"The last round of administrative measures [to cool the economy] didn't work out very well because the Chinese economy has become much more decentralized than 10 years ago," Xie says. "Administrative measures cannot be employed effectively anymore."

Central bankers' first rate hike in nine years was intended to encourage more savings as well as reassure the world. "Beijing tried to send the signal to the market that they are serious about cooling down the economy," says HSBC's Qu. It also was a sign that the country is committed to using market-based forces to control its economy.

So could global-minded investors begin watching the People's Bank of China in the same way they now watch the U.S. Federal Reserve? According to Qu, yes. In fact, to his mind, many already are.

But Morgan Stanley's Xie is skeptical, remarking that the People's Bank of China is not independent and that key banking decisions continue to be made by leaders of the Communist Party.

"It is almost like the governors of the major states in the U.S., plus the White House, plus the congressional leaders, getting together from time to time to decide whether to change the interest rate," he says. "This makes watching China's interest-rate policy very difficult." Nevertheless, he sees further rates hikes ahead, with the Chinese to lag the current Federal Reserve rate-raising cycle by two to three weeks.

HSBC, the third-largest bank in the world by market capitalization, is in agreement. "We believe China will raise rates by another 25 basis points by the first quarter of 2005 to keep the real lending rate positive as well as to curb fixed-investment growth," says Dickie Yip, the chief executive of HSBC China.

CEPA tethers Hong Kong, mainland

Hong Kong is also keenly watching Chinese investment growth as the city is still mainly an export platform for Chinese goods. "If exports continue booming in 2005, then Hong Kong will be fine," forecasts Eden Woon, head of the Hong Kong General Chamber of Commerce.

The city functions as an autonomous "special administrative region" of China with much the same laws, currency and freedoms it had under the British. But it had seen residential property prices fall by 65 percent in the six years after the handover, only to be further battered by the SARS, or severe acute respiratory syndrome, epidemic.

In 2003, Hong Kong signed the Closer Economic Partnership Agreement, or CEPA, with China, which removed many tariffs and relaxed barriers to Hong Kong's banks, retailers and other industries. The mainland also eased travel restrictions between Hong Kong and the most prosperous cities in the Pearl River Delta region, giving the city unique access to much-needed tourism.

"CEPA hooks Hong Kong to the Chinese economic boom," Woon notes.

Overseeing one of the freest economies in the world, the Hong Kong government rarely interferes with markets. "Hong Kong economic policy is not to have a policy," Woon says. "What we are trying to do is not be disadvantaged by the 'one country, two systems' policy. Then, we also aim to get some advantage." Measures like CEPA are one means to that end.

The results are quite remarkable. After growing 1.9 percent in 2002 and 3.2 percent in 2003, Hong Kong GDP is expected to expand between 7.5 percent and 8 percent this year. "Grade A" office rents are expected to rise 35 percent next year, according to consultant Jones Lang LaSalle.

'China is possibly the most friendly country to foreign capital.'
Andy Xie, Morgan Stanley

Woon believes Beijing may be using Hong Kong as a proving ground for some economic-liberalization policies six months to a year ahead of implementing them on the mainland, as with the economic agreement.

Buying in

For investors on the outside looking in, there are still opportunities to profit from the China story, observers say. Many Hong Kong-based foreign and local companies, for example, have a head start in accessing the Chinese markets as a result of CEPA. See related story.

"If you want to be a target of Chinese investment, working with a Hong Kong middleman helps attract the right investors coming out of the country," Woon advises.

Morgan Stanley's Xie believes consumer durables will be the next big story in China, as the populace continues to grow more prosperous and to boast more disposable income, but he says the low cost of labor means the manufacturing sector is still the best bet for Western investors and companies looking for profit in China.

"Manufacturing [offers] the highest return in the short term. The sector has delivered around 20 percent return in equity capital in the last 20 years," he says, predicting that wages will remain low for the foreseeable future.

The consensus, overall, is that China presents more opportunities than risks to the foreign investor. Chinese generally favor foreign brands, and there is virtually no resentment toward foreign ownership -- unusual among emerging markets. Around 20 percent of the Chinese economy is foreign-owned.

In addition, foreign companies usually get preferential treatment as compared with local firms, with a corporate tax rate of either 15 percent or nothing, depending on the sector. "China," says Xie, "is possibly the most friendly country to foreign capital."

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.